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Experience provides the best lessons. It can be hard to evaluate the pros and cons of a commodity hedge investment until you experience the volatility yourself – and those involved in the battery raw materials markets likely have.
The main issue is that investment decisions are usually based on profits. Some find it hard to conceptualize an investment based on reducing losses.
The term “natural consequences” is an apt description of the process of experiencing loss due to unhedged commodity volatility. If you have not experienced the financial toll yourself, then lessons shared by others can be measured using historical statistics.
Sizing up investments that can protect you against commodity price volatility while still generating the margins you wish to achieve is a prudent way to optimize your business. The process known as commodity hedging is a risk management strategy used to mitigate potential losses.
Producers, consumers, traders and refiners often use commodity risk management to arrive at a profit margin acceptable to a company’s growth strategy.
Part of the process is accepting that you generally diminish your potential gains when you reduce your risk.
For most participants in the battery supply chain, this shouldn’t be too concerning – you are likely in business to add value through your cutting-edge technical know-how and manufacturing expertise, and not because you have any particular interest in speculating on the direction of prices of the raw materials.
The decision to hedge commodity exposure should be based on your assumptions about your business. The ultimate goal is to achieve your desired future cashflows.
Suppose you can attain profits by using a hedging technique and simultaneously reduce the volatility in your revenue streams; in this scenario, you have created a lot of value.
The benefit of commodity hedging is greater certainty – think of it as a form of insurance.
Every hedging strategy has a cost, whether you are hedging cobalt or lithium, hedging aluminum, hedging energy, or hedging steel.
Opportunity cost is the most pertinent. If you are paying for more certainty, you are also removing the risk of more significant raw material price gains than you might have received in the future.
You also have direct costs like commissions on futures contracts and the bid-ask spread. You might also incur margin costs or derivative origination and marketing fees. Before pulling the trigger on a hedging program, you want to ensure the benefits justify the costs.
A concept that often gets lost on company management is that hedging is not an investment where the goal is to make money. The goal is to protect your company from unforeseen losses by calculating the right amount of risk for your business.
If you plan to manage your commodity exposure, you should hedge products that affect your cash flow. In many instances, the value of a company is its discounted future cash flows. If you can mitigate your market exposure by locking in future cash flows, the valuation of your company should reflect more certainty.
You may want to look at the bigger picture and determine if you have any natural hedges within your supply chain. For example, a battery maker that can reliably pass on rising lithium, cobalt and other input prices downstream to buyers of its finished products may consider itself naturally hedged. But this is not always possible. In the electric vehicle (EV) market, one group that can’t rely on adjusting their product prices from one month to another is the auto manufacturers.
Another key is to hedge only what matters – i.e., the risks that substantially threaten your bottom line. Unfortunately, higher cobalt or lithium prices make a difference for a battery maker or EV manufacturer.
Additionally, if your company has an elevated value-at-risk that can overwhelm your annual profits, you might consider reducing your VAR with financial hedges.
A question for any business manager is the likelihood of uncertain scenarios and risks. There may be differences in any year between your expected margins and your actual margins based on costs, revenues and execution of your strategy.
If the volatility of cobalt or lithium prices dramatically reduced your margins in previous years, that past outcome should stick out like a sore thumb.
It can be helpful to subject your business metrics to a theoretical stress test, helping you assess your resilience to adverse market conditions.
‘CathodeCorp’ uses lithium and cobalt to manufacture cathodes for EV batteries. In the wake of the pandemic, supply chain disruption and tightening market fundamentals drove an increase in both prices and volatility.
When the management did a post-mortem on their quarterly fiscal year ending in June 2022, they realized they had more risk than anticipated on their books. The quarterly average price of cobalt was up more than 65% year over year each quarter, with a high of 90% in Q4 2021 year over year. The escalation in lithium prices over this period was even more alarming, rising close to 500% year over year by Q2 2022.
Daily historical volatility, which describes the variance in returns of prices, also continued to escalate. The company realized for the first time that it needed to invest in protecting its margins.
CathodeCorp had always made investment decisions based on the amount of money it expected to make during a defined period. The exposure to volatile input prices made them realize they needed to determine the extent of their commodity risk and what tools they could use to protect their profit margins.
If you don’t remove volatile commodity risk, you might assume that part of your revenue stream variability is due to commodity price changes. It would help to consider whether market risk revenue generation is part of your business plan. It generally isn’t for most mid to downstream participants in the supply chain. The goal is to generate steady margins based on the growing demand for batteries, not the changes in cobalt or lithium prices.
You can use some quick calculations to determine how much an adverse move will remove from your bottom line. You can also assess your returns on a hedge investment by evaluating the maximum historical variance in those returns based on commodity price changes.
Said another way. You might need a hedging program if a two-sigma move in an input price generates a substantial reduction in your profits.
The bottom line is that you can measure your commodity hedge investment by determining the volatility of losses and calculating the amount you want to pay to secure the profit margins you seek.
Commodity hedging investments mitigate potential losses. You can measure the benefit of your hedge investment by comparing the potential gains relative to outsized losses and the volatility of your returns (using a VAR calculation).
If you would like help in determining if your business would benefit from commodity hedging, please reach out to our risk solutions team.